Inflation is not a price phenomenon

It never ceases to amaze me the “ignorance” about inflation, even from people that should know better. In the WSJ, Kathleen Madigan writes: “Link between weak dollar, inflation is eroding”:

Exchange rates are a hot topic as the U.S. and China hold their third annual round of the Strategic and Economic Dialogue this week. The link between a weaker dollar and prices is also gaining in importance because the Federal Reserve is coming under fire about inflation pressures in light of rising commodity costs. The Fed says the effect of such cost increases are “transitory.” Businesses and consumers aren’t so sure.

The figures show the absence of any link between the trade weighted value of the dollar and inflation (CPI Core) in different moments over the last 10 years.

In the latest Economic Synopses released by the St Louis Fed, veteran researcher Daniel Thornton proposes to test the hypothesis that the FOMC focuses on core inflation measures because “in light of the volatility of food and energy prices, core inflation has been a better forecaster of overall inflation in the medium term than overall inflation itself has been over the past 25 years”. He concludes:

This essay notes that the evidence that core inflation is a better predictor of future headline  inflation is mixed and presents the results of a simple test of the proposition that core inflation is a better predictor of future headline inflation than headline inflation. The essay concludes by showing that over periods of interest to consumers, the difference in the loss of purchasing power reflected by the core and headline measures is economically relevant.

The following picture shows that over a long period of time (last 40 years) the headline CPI and Core CPI have increased by the same factor. Their “paths” have differed sometimes markedly. Those are moments of significant relative price changes (in the 70´s or over the last seven or eight years). The point to note is that relative price changes can take place within an overall inflation process (the 70´s) or not (more recent period).

During the 70´s the Fed (Burns) compensated the negative oil and commodity shocks with expansionary monetary policy (increase in nominal spending). As Friedman had said in 1968, the result would only be more inflation without gains in output or reductions in unemployment. And that´s exactly what happened.

In 2008, paying attention to headline prices, the Fed (Bernanke) indicated that nominal spending would be contracted. Given the environment (financial crisis) this was tantamount to “rubbing salt in the wound”. Nominal spending crashed and the recession became “Great”.

Not to worry. As long as policymakers are focused on “inflation”, the economy will not revive, but many will be “happy” because “prices have remained stable”.

According to Kocherlakota:

In remarks that closely tracked a speech he gave last week, the head of the smallest regional Fed bank said he sees core inflation rising by year’s end to 1.5 percent, still short of the Fed’s informal 2 percent target, but nearly double the rate last year.

If that forecast pans out, “The Fed would then be closer to its price stability mandate – and so should ease the pressure on the monetary gas pedal,” he said. “My recommendation in this scenario would be to raise the target fed funds rate by 50 basis points,” he told the Forecasters’ Club of New York.

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